6.13 IBM Example

Our historical analysis of IBM suggested a growth rate of dividends of 8.  This is higher than the economy’s growth rate, and was greater than the discount rate, so we could not use this in the one stage model. Let’s see how the two stage model values IBM if the first stage growth rate is 8% and the remaining parameters are as shown on the screen:

Compare this to the one-stage model with the same parameters:

You can see impact of limiting the second stage growth rate on the valuation.

When you calculate the two stage model, Valuation Tutor provides you with the details of the calculation:

This shows you exactly how the values are calculated, and serves as a reference point for understanding the details.  You can export this into Excel and see if you can verify the steps of the calculation.

Projecting Future Prices

As we noted before, Valuation Tutor also reports the implied expected return.  One way to use that number is to project future prices.  For example, if the current price is $100 and the expected return from the valuation model is 10%, then you have a projected price, or a price target of $110 in one year.

Criticism of Model 2

The two stage model is a clear improvement over the one stage model particularly because it lets us restrict long term growth in an economically meaningful manner.

But three major limitations remain:

i.                    The model only applies to stocks that pay dividends and have a stable dividend policy.  But many companies have a more complex dividend policy that consists of both accounting dividends and Treasury stock purchases.  These purchases create important changes to shareholders equity that are not accounted for in the dividend model

ii.                  Implicit in the model is the assumption that the firm is a going concern.  Some firms may be distressed, and the model will not be useful for these companies.

iii.                The model is clearly not applicable to a non-dividend paying stock. 

In the next chapters, we introduce extensions of the dividend model that can overcome some of these limitations.    These are the free cash flow to equity model, residual income model and the abnormal earnings growth model.  In Chapter 8, we study a model specifically applicable to distressed stocks.